Global Economics

Telef??nica Gets the Last Laugh

Controversial acquisitions have helped make the Spanish company Europe's top telco and??ith 40% net income growth??ts best-performing

You have to grant C??sar Alierta Izuel a bit of gloating. The low-key chairman and president of Spanish telecommunications giant Telef??nica suffered a lot of skepticism last fall when he shelled out an eye-popping $31.4 billion for British wireless company O2??he biggest telecom acquisition in 2005 and one of the top M&A deals of the year. Telef??nica (TEF) shares dropped 14% in the days following the bid, to ??12.16 ($15.44), and some analysts lowered their ratings on the company.

Fast-forward to July 27, and with O2 in his pocket, Alierta now presides over Europe's best-performing big telco. Thanks to the addition of Britain's No. 2 wireless operator and Prague-based Cesky Telecom, which Telef??nica also bought last year, revenues for the first half of 2006 grew 46% from a year earlier, to ??25.2 billion ($32 billion) and net income grew 40%, to ??2.6 billion.

Even stripping out the contribution from the new properties, Telef??nica turned in respectable 7.7% revenue growth vs. the first half of 2005. That compares with 2.6% organic first-half growth reported on July 25 by Telecom Italia (TI) and paltry 1.4% growth at France Telecom (FTE). Alierta didn't speak publicly about the results on July 27, but at the annual shareholders' meeting in May he crowed, "Telef??nica is growing and will continue to grow more than other operators."

GROWTH TRAIN.

No question, Telef??nica is on fire. With the addition of Cesky and O2, plus continued growth in the Latin American businesses it bought from BellSouth (BLS) in 2004, Telef??nica has now become the third-largest telecom operator in the world, by number of clients, after China Mobile and China Telecom. All told, it has nearly 192 million "accesses" around the world??ixed line, broadband, and cellular subscribers.

What matters, of course, is the revenues Telef??nica manages to squeeze from those customers, and the numbers are impressive there. It now counts 6.8 million broadband DSL subscribers, up nearly 50% from a year earlier. Revenue growth in its big Latin American operations, which account for 35% of Telef??nica's top line, came in at a decent 4.4%, adjusted for a sharp rise in the value of the euro.

Telef??nica is even managing to find gold in saturated and competitive European markets. O2's British business surged 15%, compared with flat results for France Telecom's Orange unit and a 1% uptick for Vodafone (VOD). "It's not a flash in the pan," says Peter Erskine, the former chief executive of O2, who now runs the Telef??nica O2 Europe unit. "We are very much pulling the lever of growth."

Analysts are impressed. "Telef??nica is a better managed operation [than rivals]," says Bosco Ojeda, an analyst with UBS in London. "It has positioned itself in high growth markets, both in terms of geography and products." Ojeda particularly likes that Telef??nica is managing to maintain its market share in existing services, while going aggressively after new offerings such as DSL and Internet TV.

STRATEGIC SHIFT.

It wasn't always clear that the Madrid-based company would be such a star. The former state-owned Spanish phone monopoly, it was fully privatized by the then-ruling center-right government of Jos?? Mar??a Aznar in 1997. Ownership is now widely distributed: The two largest shareholders are Spanish bank BBVA (BBV), with 5.6%, and Spanish savings and loan La Caixa, with 5.4%, and 90% of the shares are in free float. The lack of state control lets Telef??nica move more nimbly than rivals such as France Telecom, which is still partly state-owned and whose employees remain civil servants.

After privatization, Telef??nica embarked on an aggressive expansion effort in the Spanish- and Portuguese-speaking world, culminating with a $5.85 billion deal in March, 2004, for the Latin American assets of BellSouth. Investors and analysts comfortable with that approach were thus thrown by Telef??nica's sudden moves last year to beef up in Europe (See BusinessWeek.com, 11/1/05, "Telef??nica Rings a Big Bell").

"O2 was expensive and the move was a change in strategy from being the telecoms leader for the Spanish-speaking world to suddenly being in other parts of Europe," says Miguel Jimenez of securities firm Renta 4 in Madrid. "Investors weren't prepared for it."

Alierta moved fast to assuage concerns, reducing head count, cutting costs from the combined operation, and selling off a few noncore operations. After the May shareholders' meeting, Telef??nica's shares finally began to come back to life. They're now trading at ??13.25, up 12% from their postmerger low.

WHAT NEXT?

That makes Telef??nica the most valuable full-service telco in Europe, with a market capitalization of ??65 billion ($82.5 billion), though Vodafone's is still about twice as large. Curiously Telef??nica's price-earnings ratio of 12, though slightly higher than most traditional European telcos, is just 40% to 60% that of big U.S. telecom firms such as AT&T (T), BellSouth, and Sprint Nextel (S).

So what now for the new top dog of European telecom? Alierta vows he's off the acquisition trail for the time being, concentrating instead on improving operating results. He has promised shareholders to increase earnings before interest, taxes, depreciation, and amortization (EBITDA), now 36.7% of revenues, by two percentage points by 2009. He also aims to double per-share profits and dividend payouts within four years.

He also has to work down Telef??nica's massive ??55 billion ($70 billion) debt, which rose by ??25 billion ($32 billion) last year thanks to the acquisitions. At 2.7 times EBITDA, the debt load is high, but not above the critical 3x threshold that can trigger credit downgrades.

One thing Alierta likely doesn't have to worry about is being on the receiving end of a hostile takeover. "The O2 acquisition gave Telef??nica enough bulk so it really is too big to be acquired," says UBS' Ojeda, who figures the company has an enterprise value (net of existing cash and debt) of ??115 billion ($146 billion).

Not a bad turn of events for a former state-owned phone monopoly. Telef??nica may no longer be a monopoly, but it is monopolizing good news among Europe's telecoms.